This study
has attempted to present an outline of stock market on the basis of Islamic
standards in the following five sections. The paper has confined specially
to equity market.

Section I : Introduction to Equity Investment

Equity capital represents ownership
capital. Equity shareholders collectively own the company, bear the risk and
enjoy the reward of ownership. The potential rewards and ownership
associated with equity shares make it an interesting financial asset unlike
debt. Debt owners are sleeping partners with no active involvement in the
business but with fixed income from debt. In Islamic finance, equity
investment involves Mudarabah finance where capital owner and investment
manager, distribute profit in accordance with agreed ratio. Financial loss
is borne by the capital owner, the loss to the manager is the opportunity
cost of his labour, skill and technique of management. The management
however does not give guarantee of capital as well as profit. It may be
noted that present Mudarabah participants can not consist of one or two
capital provider and one or two managers who share profit. Today equity
participation is through issue of equity shares to a very large number of
investors by a corporate which is a legal entity. So only equity investors
in capital, are the owners and management works as employees or hired
professionals. Hence they do not share the profit but get salaries and other
benefits which appear as cost to the

The Author is Former Economic Advisor to Securities and
Exchange Board India (SEBI), Bombay. He was also Senior Director in Reserve
Bank of India, Bombay and Visiting Officer to IMF. The Author has received
good support from Prof. S.A.M. Hashmi, Principal of Akbar Peerbhoy College
of Commerce & Economics, Bombay. Mr. Ansari Rehan, Executive Assistant from
the same College. Special Thanks to Mrs. A.M.Y. Khan (Author’s wife) who
went through the draft a number of times.

company. However one fact remains constant, the equity
shareholders only are the partners. Crucial role of capital market was
highlighted by Hicks. Hicks (1969) argued that industrial revolution was
possible on an economic scale due to investments of large magnitude made
in highly liquid market. According to Hicks, it is the availability of
liquid assets which is crucial and has been made possible by financial
markets and development of liquid capital market. When we talk of capital
market we mean the market where financial assets of long maturity like
equity shares, other shares, bonds issued by corporates, securities issued
by the Government and units of mutual funds are issued to mobilise financial
resources from the savers (investors) by the primary deficit units. A number
of intermediaries operate in the capital market to facilitate funds
mobilisation and trading of them. These intermediaries in the primary market
are merchant bankers, advisers to issue, registrars and underwriters. The
secondary market includes stock exchanges, brokers, traders/dealers,
depositories, clearing banks/clearing corporations. Since Islamic financial
system prohibits interest bearing instruments, this paper would confine only
to equity finance from capital market.

Why a firm should go for Equity?

Equity itself means fairness or the
application of principles of justice. In capital market, stocks or shares
not bearing interest have been defined as equity which confers ownership on
investors and a right for dividend from a profit earning company. Every
investor gets his reward according to size of his investment. Hence equity
finance is crowned with fairness and justice. Equity partnership besides
dividend, offers several benefits to investors as analysed below :

i. Equity market makes investment less risky;
more profitable and more attractive by making it liquid. Liquid equity
market improves the allocation of resources.

ii. Corporates with a large amount of
debt have agency problem between creditors and managers. High profile
management prefers to borrow for expansion of the company. When the debt
equity-ratio rises, management has plenty of borrowed funds induced to
commit “adverse selection” in identifying projects. Larger the firm’s debt,
higher the risky investment and lower the profit due to non-performing
assets. Hence debt owners hardly get repayment of debt and interest. If
funds are raised by way of equity, owners of the company are more vigilant
and accountable. As a matter of fact companies with high equity are better
managed and management executives can be controlled by equity holders. So
equity investment is superior to debt investment.

iii. We now look from the agency cost point of
view. Agency cost of debt is borne by the firms’ owners as a result of
potential conflicts between debt holders and equity holders. The choice of
capital structure can reduce the cost arising from such conflicts. Doherty
(2000) highlights the agency cost arising from the fact that equity holders
have limited liability while debt holders have fixed minimum return. In the
event that company is successful, a maximum gain goes to equity holders. If
the company is not successful, debt holders also bear the losses along with
equity holders. Thus the lending is less safer than investment in equity
stocks as equity holder can control the policies of the company. The value
of firm rises with the increase of equity. So investor should invest more in
equity. In a growing concern, the companies find it cheap to raise funds
from equity market. Price discovery is of paramount importance as price is
determined by the market forces in equity market. On the other hand, debt is
some what illiquid asset and price determination is difficult as it is
generally not traded.

iv. Modigliani and Miller showed that
deductibility of interest payment from profit makes the firms rely more on
debt. But there are evidences that companies with large borrowings and high
debt become sick and insolvent. Their bad debt and interest liabilities
exceed their net worth resulting in insolvency. This has generally happened
when business faced demand recession for a few years or downward -business
cycle persisted during this period or management turned to be dishonest and
careless. However, equity dominated firms have withstood such crashing
periods while debt dominated firms have collapsed. As a matter of fact high
debt liability which sometimes can bulge for no fault of the company’s
owners, can wipe out the entire net worth of the company.

v. Experts on industrial economics suggest that
in industries where there are little concerns on how things should be
managed, allocation of resources through stock market is desirable. This is
because stock market provides a way of checking that firms are well run when
there are divergences of opinion on how firms should be managed.

vi. The debt and interest liabilities grow
irrespective of the condition of the company. We have the experience, that
debt liabilities of many developing countries made them insolvent due to
servicing of external corporate debt. The outflow of capital on account of
debt service has exceeded the fresh capital inflows. Large capital outflows
put pressure on exchange rate and foreign exchange reserves of the domestic
country.

vii. In terms of international finance,
foreign investors’ participation by way of foreign direct investment
(equity) brings with it entrepreneurship, foreign technology, techniques and
expertise.

viii. Equity issues go through screening by
the board of directors and executives before issue. A number of disclosure
norms have to be satisfied and companies have to be rated by credit rating
agencies. Consequently equity investment as well as funds raising by issuing
equities is more objective oriented while management can borrow debt without
facing any scrutiny which can be used for undesirable purposes.

ix. Stock market functions as a scrutinizer of
financial performance of corporates and serves as a guide to promote
efficiency. It is known that a continuous valuation of companies is
reflected in stocks prices and declaration of dividend. In the event, stocks
prices start declining, possibility of takeover and merger emerges as a
threat cautioning a company and its management to have financial discipline
and efficient funds allocation. Another role of market prices is that they
facilitate risk diversification through international integration, encourage
a shift to higher return projects and help to promote growth.

Section II : Organising the Islamic Stock Market

Early Views on Stock Market

The early authors of economics used the
subject of stock market as an example in their discussions of competitive
market conditions. Subsequently, the subject was expanded to the role of
prices in the stock market in allocation of resources, providing incentives
for accumulation and employment of capital. Although the development of
stock market was discussed in neo-classical literature, the economic theory
underlying the traditional form of the rational market view was developed
during early 1990s. Recently, the efficient market hypothesis with the
development of rational expectations has emerged as a point of discussion
among the academicians in the area of economics and finance. The strong view
that stock markets are efficient has invited a number of criticisms both as
an observed empirical phenomenon and as an analytical concept.

Walras argued that stock market is perfectly
competitive and equated it with a general equilibrium theory as attempted to
generalize the particular form of fund in Paris Bourse. To him, the
equilibrium prices are established through a process of an auctioneer
calling out prices and Edgeworth-type recontracting so that no transactions
are committed until market clearing price is called out. Walras cited that
“stock market exchanges in a large investment centre like Paris or London”
are an illustration of “how competition works in a well organised market”
(in Elements of Pure Economics,1874).

Alfred Marshall agreed with Walras while
indicating about stock exchanges. In his Principles of Economics, he gave
illustrative real world examples of competitive markets. According to him
stock exchanges are the pattern on which the markets have been and are being
formed for dealing in many kinds of produce which can be easily and exactly
described as portable and in general demand. He emphasized international
securities which include Government Bonds and the Stocks and the bonds of
Certain Great Corporations, for which there is a world market and a world
price. However, there is little in Marshall’s Principles to connect stock
exchanges with the function of capital accumulation and accommodation.

Stock market can be organized as an exchange
or an over-the-counter (OTC) market. An exchange is a physical location
where buyers and sellers come together physically or through electronic
instructions to buy and sell securities. In contrast, over-the-counter
market permits buyers and sellers to transact without meeting at one
physical location or through computer linked network. Though many
instruments like corporate bonds, debentures, Govt. securities, derivatives,
commodities, etc. can be traded on stock exchanges, but this paper has been
restricted to equities market.

Islamic stock exchange will have to be setup
on the basis of Islamic Principles through equity participation. The stock
exchange will not provide trading facilities for debt instruments, stocks of
companies being financed by debt and companies manufacturing goods and
services not compatible with Shariah Laws. Ownership of stock exchange will
be with its shareholders. For achieving fair functioning of stock exchange,
its shareholders will not be allowed to participate in trading and will not
be permitted to be the partners of any other player in stock market.
Distribution of dividend to shareholders of stock exchange will have to be
linked to actual profits of the period under consideration and its shares
will not be tradable. Dividend distribution has to be restricted to profits
of the year so that accumulated reserves are not distributed. The
shareholders could be institutions as well as individuals. The shareholders
will have to observe all laws based on Shariah and will be subjected to
corporate governance based on Islamic provisions or Islamic code.

A Resemblance between Mudarabah Company and Modern
Joint Stock Company :

Ownership of a company through equity shares
in modern ownership concept, corresponds to partnership firm in Islamic
Jurisprudence. Though Islamic scholars have specified a number of varieties
of partnerships like Sharikatul-Amwal, Sharikatul-Sanai, Sharikatul Wajuh
and Mudarabah. Except Mudarabah other varieties specified above would refer
to proprietary and partnership companies with small scale of operations
controlled by the owners themselves along with small partners in trade and
commerce. This type of sectors today forms the unorganized segment of the
business in any economy. Mudarabah financing today would involve promoting a
company by the promoters by way of contributing capital and assigning the
management of the same to professional managers. Though ownership and
management policies may be framed by the promoters, execution remains with
the executives and risk is to be borne by the promoters. Since medium and
large companies seek billion dollars of resources, the number of
shareholders also (partners) is very large, for the sake of accountability
and recognised identity. Such companies have to be registered with
Government authorities, so that investors intending to become partners from
long distances are sure of the personality of the company. Finally, the
company is personified as a legal entity for functional purposes. You would
see that present day joint stock companies are replica of Mudarabah
companies and have to function according to mutual agreements and government
regulations. We may explain one important point that most of the Shariah
laws were given interpretations in early period of Islam when concept of
industry involved only partnership firms and exchange mechanism was limited
to geographical contiguity where number of economic agents personally
knowing each other was small. Hence, there was physical contiguity among the
partners. Today when a company has 50 thousand or 80 thousand shareholders
scattered over the far flung areas, their personal relationship does not
exist but the company has continuity of life because ownership of company is
dispersed over million shareholders. Exit of few such partners does not lead
to closure of a company.

Identification of Islamic Joint Stock Company

Islamic Joint Stock Company is that in which
owners or contributors of financial resources invest their own savings on
profit/loss basis. The company should not have any debt or any liability
bearing interest rate in terms of money or in any non-monitory form. The
company should not manufacture any product or service which is prohibited by
Shariah. The company should not engage in exploitation of consumers, factors
of production and natural resources given by God. The company should not
indulge in over pricing and under pricing. The company should not obstruct
free market forces. Corporate social responsibility is also the preamble of
Islam. If the corporates do not develop moral and ethical standards and they
are not accountable to them, their animal spirit to maximize their profits
can lead to unfair business practices sacrificing externalities and social
ethics. It is very well known that corporates with sufficient profits give
money to finance public entertainment, or to local rehabilitation programmes
or roads and parks development. Social responsibility has a wider meaning
than conveyed by monetary donations and financing social events. Ethical
behavior is an integral part of the responsibility, which every
company/corporation owes toward that society in which it operates. Social
responsibility is independent of the size of profit. To the extent any
corporation abuses the society, it becomes threat to the society’s welfare
and health. A company has to observe “ethical behavior” and “social
responsibility”. That is why Shariah does not permit collusion which can
result in cartel or monopoly of factors of production, of production itself
and that of distribution of goods and services, and in exploitation of
society. Such companies can not find place in capital market under Islamic
frame work.

Why company should go to stock market

An advantage in going to stock market for
trading is that company has to register on stock exchange and consequently
gets national level recognition and creditability with its expected new
owners, customers, employees and suppliers. Moreover, Stock exchange
scrutinizes the character and sources of funds of company in all respects.
According to Quran everybody must acquire resources rightfully in accordance
with Islamic code, otherwise it would be a violation of Shariah conditions.
Besides, stocks prices provide very valuable information. Everyday investors
buy and sell shares making their judgment on prospects of a company.
Moreover, exchange information leads to wider awareness among the investors.
Firms may be able to obtain capital at more attractive terms from the
market. An Islamic company will have to mobilise large resources for capital
formation on this basis if it has to compete with large multinationals.
Disclosure of character and motives of promoters, rating of company,
disclosure of material information to investors, at the time of making issue
by the company through stock exchange are mandatory. Shariah code of conduct
verification would have to be certified before issue. Now we can understand
that going to stock market is a proof that company is meeting all conditions
of Shariah.

Trading in Equity Stocks and Islamic view

It may be said at the outset that Islam is
for a fair and free market. The Holy Prophet (may peace be on him)
discouraged any interference in the process of price determination by the
state or individuals. Beside refusing to take any direct action, he
prohibited the business practices which could lead to market imperfections.
Consequently, stockholding, speculation, oligarchic collusion, concealment
of vital information about the product and selling by false vows (misleading
advertisement of the present day) were prohibited by Holy Prophet (may peace
be on him). Thus the holy prophet (may peace be on him) nullified the
influence of economic power on price mechanism. An equity share represents
the net wealth of the company which can be traded. Islamic scholars are in
agreement that stocks corresponding to Mudarabah partnership certificates
can be exchanged or traded like real commodity which has a value in real
terms. The investors have to purchase equity shares with real intention of
investment and to hold them as a partner in the company. In other words
equity shares have to be purchased to become partner and not for trading for
profit making. This would be in Shariah, compatible to Mudarabah which is
partnership in real sense. Of course, immediate sale of instrument can be
made to meet unseen needs arising all of a sudden.

In this section it is proposed to define and
explain some transaction activities in stock markets which are unlawful
according to Quranic and Shariah injunctions. These activities are frauds
and unfair practices in sales and purchase which are discussed below.

Frauds in Trading

Islamic Shariah has prohibited frauds in exchange of
goods and services. The same is valid for transaction of shares which
include an act of buying and selling or subscribing to an issue of any
security or equity shares or agreeing to buy and sell. In Islamic view fraud
means any action, expression, omission or concealment committed whether in
deceitful manner or by a person with his convenience or by his agent dealing
in securities in order to induce another person or his agent to deal in
securities, whether there is any wrongful gain or avoidance of any loss.
Fraudulent action would also include misrepresentation of truth or
concealment of material fact in such a way that opposite party acts to its
own detriment, an incorrect suggestion knowingly given by one party to
another party for purchase or sale, an active concealment of fact having
knowledge of it, a promise made without any intension of performing it, any
presentation made in reckless and careless manner, a false statement, giving
out misinformation adversely affecting the market price of security,
planting misleading news, predating or falsifying records, etc. Malpractice
and manipulation is committed when buyer or seller of securities creates
false or misleading appearance of trading not intending to effect transfer
of beneficial ownership but only to inflate prices (Ghaban) or cause
fluctuations (volatility) in price of securities for wrongful gains.

Short Selling or Long Buying is Prohibited

A short sale is a sale of securities which
the seller does not own at the time of affecting the sale or goods do not
exist at the time of sale. This type of transaction is not permitted
according to Sanani Ibn Qudama (WD) and Ibn Humam (1317H, 13/1P, 4/55,
6/36). Similarly if a purchaser of stocks buys long but does not have cash
in hand or in bank or is likely to get his own money in due cause, is
prohibited to do such deal because he adds fuel to price. As a matter of
fact, a long position is one where trader buys the securities without the
intension of having them or without the intention of accepting delivery.

Prophet, the honourable (may peace be upon
him), did not approve sale of goods which seller does not own in his
possession at the time of executing the sale. In financial market it is
called short selling which has the potential of being misused for rigging
the market prices. Moreover, short selling results either in extra profit
making or defaults by the seller of securities. In capitalist frame work,
short selling cools the stocks inflation expected to occur in the future by
supplying the securities in the market. Short seller is trader in the stocks
market. He sells equity shares to be delivered on a future date at a
determined price in the expectation of fall in stock price before the
settlement date and during this period he buys the stocks to make delivery
at settlement date. Mostly there is no delivery and the trader gets
arbitrage between the sale and purchase price. Short selling or long buying
results in slump or shooting up of the market leading to crash of the stock
prices or in major default blocking their payment and settlement culminating
into bankruptcy and liquidation of financial system. Islam therefore has
prohibited short selling in all types of trade. In the capital market short
selling involves speculation. Similarly, long buying or using margin trading
for long buying stimulate speculation resulting in stocks boom. The trader
may pay margin on positions and can postpone settlement for next round. The
long buying is financed by bank borrowing. In speculative market, turnover
and velocity is very high because same quantity of shares/stocks change
hands several times. This is false trading or false transaction activity
because in terms of money value turnover rises but the quantity of stocks
traded remains mostly the same. It does not add any real value to the
company of which shares are overtraded. There is no additional capital
formation in the economy. These activities add fuel to the market.

We may specify that speculative sales and
purchase in short selling or otherwise generate “Gharar” or uncertainty in
the outcome expected by the investors. The markets have experienced
recurring volatility in stocks prices during booms leading to uncertainty
and economic instability while short selling has ruined the investors.
Economic instability results in distortion in investment planning of
entrepreneurs.

Process of Crisis in Short Selling

Short selling could result in a loss if price
of equity share rises instead of falling in the subsequent period. The
losses in short selling shoot up because there is no limit on price rise.
Many a times bulls generate price spiral artificially by cornering the
floating stock. This occurs frequently whenever there is large scale short
selling and bulls know that short sellers would need to make purchase to
cover their short sales. A steep shortage of floating stocks arises due to
cornering of supply of stocks by the bull and this act of bull pushes up the
stock price artificially. Thereafter short sellers find it difficult to
purchase or borrow same stock except by buying at a very high price from
bull. On the other hand, there is an opposite case when bull gets
overextended due to accumulated large positions financed by short term
borrowing and the bears who would have come to know about bull buying spree,
start heavy selling. They cause market price to sink and impose heavy losses
on bull who is not able now to repay short term borrowings to lending bank.
This manipulative game between bulls and bears can make even lending bank
bankrupt and insolvent. Thus a default by a large trader can have a chain
reaction percolating to insolvency of many banks resulting in defaults to
million depositors.

Insider Trading in Islamic View

Islam / Quran has focused on education,
knowledge and correct information available to all concerned people.
Transparency in information is equally important for all since lack of
transparency can lead to misunderstanding of facts (Jahalat). According to
Islamic view, an investor or any other entity associated with market
activities should have knowledge of rules and regulations issued by the
government authorities and Islamic law authority. They should also be
competent in the knowledge of market mechanism before engaging in equity
transaction (see Al-Ghazali, 1992, P-328). Therefore, in any transaction,
parties have to be very seriously accountable to facts, information and
rules and regulations including ethics. In case of violation of these
principles, a number of times, trading in shares results in insider trading.
Insider trading involves a person (director of the company or any person
associated with the company) who either on his behalf or on behalf of any
person, deals in securities of a listed company on any stock exchange when
in possession of unpublished price sensitive information not available to
others. Insider trade also occurs when insiders communicate, counsel or
procure directly or indirectly any unpublished price sensitive information
to any person who can use this information to sell or purchase the stocks.
Sensitive information could be defined as financial results, intended
declaration of dividend, major expansion plans, expected mergers /
acquisition and any other information likely to affect the profitability of
the company. According to Shariah, all the information of the company should
be known to dealers / brokers / investors in the market and should not be
monopolised by insiders only. The information should be presented in
understandable manner.

Hiding of information and presenting it in a distorting
manner by the insider or cornering the information is against teachings of
Islam. It is totally illegal in Islamic view to trade on the basis of
information which has not been yet made public. Insider trading as a matter
of fact violates market efficiency and insiders can realize abnormally high
return from trading by using the information they alone know. In capitalist
economy which works without ethics, promoters of firm, directors on the
board of the company, management executives produce false information and if
unrestricted, can realize personal gains by selling shares short while
jeopardizing the profitability of the firm and settle the trade by making
purchase when prices have fallen.

Market Efficiency and Securities Trading in Stocks
Market

In modern capital market, market efficiency
is an important and crucial feature of an ideal market in which transaction
price should not differ from equilibrium value of stock. In reality
transaction prices generally differ from equilibrium values that can be
achieved only in frictionless market. It is generally hypothesized that
market prices reflect all information. There is a view that prices at which
stocks have been traded may reflect lagged adjustment transaction cost.
Efficient Market Hypothesis stipulates three types of situations namely weak
form efficiency, semi-strong efficiency and strong form efficiency. Let us
have some more explanatory discussion on efficient market situations.

Weak Form Efficiency focuses on informational content
of the previous sequence of stock price movements. The current prices of
stocks reflect all information found in the record of past prices. Thus
there is no relationship between past and future price movement. According
to Weak Form Efficiency price changes are not independent over time. How
much information these movements contain for a market to be informationally
efficient? If the market is frictionless, the answer is none. Alternatively
speaking, in informationally efficient market abnormal returns cannot be
earned by using trading rules based upon price movements. Many studies have
been attempted to test whether lagged information work as input in current
price formation. Findings have shown that prices adjust to news available
before an event has occurred. Therefore profitable trading strategies can
not be developed in relation to an event after it has occurred.

Semi-Strong Form Efficiency is about the speed at which
pieces of public information are reflected in stock prices. The stocks
prices adjust rapidly to all publicly available information. The
announcement of a piece of information is considered an event which is
utilised by investors within minutes and prices adjust completely to their
previous level. Thus the traders in stocks will not be able to earn
superior return by using publicly available information.

Strong Form Efficiency refers to hidden information
which is extracted by the analyst. The hypothesis holds that all available
information, public or private is reflected in price. This is superior input
to earn huge profit. However better informed investors do not earn higher
return because better information is costly. Informational efficiency
requires that marginal return should equal the marginal cost of obtaining
information.

However, markets are never perfect and
frictionless. The efficient market hypothesis, is subject to a number of
other variables besides information relating to company and its stocks.
These variables are speedy settlement of trade, quick delivery and payment
system, safe transaction of funds and financial instrument, no fraud and no
manipulation in the market. According to Islamic view, information based
price discovery is a partial solution of the problem of pricing. Islam
focuses more on quality of information. The data reflecting information
needs proper coverage, definition and correct analysis so that rumour based
trading is stopped and investors can do transaction in securities on the
basis of their rational results estimated quantitatively by using
fundamentals of the company including all material information.

Market efficiency according to Islamic
Jurists differs from capitalistic view of efficiency which has given
emphasis only on trading efficiency based on information system. Equilibrium
price is determined by the forces of investment maximization and related
utility maximization objectives and not by demand and supply of stocks only.
High profitability or excessive profitability due to hike in price caused by
various market imperfections is not supported by the Shariah. Hence profit
should occur on the basis of genuine demand and supply in competitive and
perfect market without using drawbacks of the stock market as discussed in
this paper. In perfect market only normal profit occurs otherwise demand and
supply factors come into motion to wipe out excess profits. As such profit
should not be generated by artificial demand or supply of stocks. Islam
permits profit on account of price but on the basis of genuine demand with
the intention of investment. According to Anas records, during the lifetime
of Prophet (may peace be upon him) price level went up. People requested him
“Messenger of Allah (may peace be upon him)! Fix the price for us.” On this,
prophet (may peace be upon him) said “Prices are fixed by Allah. He
contracts and expands the sources of livelihood. And I hope to meet my
sustainer (God) in a state that no one raise a claim of injustice against me
in respect of blood or money.”

So Islam does not interfere in the price mechanism and
recommends that demand or supply of goods or assets should not be distorted
by any manipulation and friction.

In Islamic frame work, price of stocks should
reflect intrinsic value of stock backed by the networth of the company. We
can define it as economic value or book-value of stock.
V = E + R + S
.

N

V =
Price of stock, E stands for equity paid up capital, R for Reserves and N
for Number of shares, S stands for Surplus.

Financial accountants evaluate the value of
financial assets on the basis of discounted future cash flow from the asset.
The discounted sum works out to Present Value (PV) of the future cash flows
as given below :

PV = C1 +
C2 + C3 - -
Cn .

(1+r)1
(1+r)2
(1+r)3
(1+r)T

C = Cash flows, r = Discount rate

The above relationship depicts future cash flows. The
discount rate contains a risk adjustment factor and is related to systematic
risk. The assumption is that unsystematic risk would be taken care of, if
the income of firm has been diversified. The condition of equilibrium would
be arrived when market price of a stock is equal to Present Value of future
flows of dividend from the investment. It is possible at this stage that
present value may exceed the economic value of stock. In this situation an
investor would be earning some capital gains at market price. Islamic market
should oscillate between economic value and present value of share.

Shariah Position on Risk Management

The owners of a firm hold partnership through
holding shares of the company which is listed on stock exchange providing
the opportunity of selling and purchasing the stocks on the basis of demand
and supply. As such the investors main concern is the value of their shares.
It is worthwhile to state that investors are risk averse because risk
reduces the value of shares. Therefore any reduction in risk by using risk
management strategies will protect the value of shares. Since Shariah also
recommends maintenance and protection of wealth, an investor has to protect
his investment value from risk otherwise he violates the Islamic teachings.
If we do not protect our assets from risk, we are involved in squandering of
wealth. It is prohibited by Quran. Again we are trustee of wealth appointed
by God so we have to protect it by all fair means.

Islamic market shows concern for excessive
profiteering. Market efficiency does not guide the price to reverse back to
original point but helps to settle it above original and below boom point
and that way equilibrium price goes on shifting upward. If you look at any
price index for last 15 years, you will see this trend. It happens that
stock prices by and large have no link with fundamentals of the company
during short term and trading in stock market and stocks prices are
determined in short term only.

The very objective of the Shariah is to
promote welfare of the people which lies in safe guarding their faith, their
life, their intellect, their prosperity and their wealth whatever insures
the safe guarding of the firm, serves public interest and it is desirable -
Al-Ghazali. Hence, risk which can inflict damage to human beings is socially
not desirable. We must take all legal measures to avoid risk.

If risk is not mitigated, it can lead to
financial disaster and economic instability ; Risk management has to be
adopted at investors’ level as well as on stock market level since equity
stocks are under consideration as financial assets. According to Islamic
provisions, “Severe damage (darar) has to be reduced and can be substituted
by lighter damage” and damage (Darar) has to be avoided as far as possible.
Thus risk has to be mitigated. As such risk containment measures have to be
used as recommended by Shariah. Risk in financial assets is broken into two
components namely systematic risk and unsystematic risk. Systematic risk
associated with equity shares is systematically related to market. This risk
originates from the market events and it is not specific to a stock of the
company. On the other hand unsystematic risk is generated in the company to
which the stock is related. This risk can be eliminated by diversifying the
investment (portfolio approach). As unsystematic risk is not relevant to
risk management, it is systematic risk which has to be managed. This risk
arises from market due to over trading, very large exposures, manipulations,
frauds, short-selling and long-buying, insider-trading, informational
inefficiencies, inefficient clearing and payment system and lack of
transparency in the market. Thus it is the imperfection in the market which
can create systematic risk for investors. Of course, there could be natural
factors like macro economic fundamentals which can also effect the market in
positive or negative sense.

Section III : Stocks Market Today in
Capitalistic System

Stock market today occupies an important
position in the economies of many countries like United States, UK, Germany,
France, Japan, India, Malaysia and many other countries. Stocks markets in
the world have gone through a number of reforms and substantial growth.
Every stock exchange is supposed to set goals of investor’s protection, safe
and efficient market with efficient allocation of domestic savings and
trading mechanism, low cost of transactions. Markets have to follow
stringent disclosure norms, credit rating norms, free pricing and book
building for price discovery in the primary market where companies enter to
issue equity stocks. Even intermediaries institutions that assist primary
market, are regulated by the Regulatory Authority. Merchant Bankers,
underwriters, registrars, custodians, brokers, etc. have to meet capital
adequacy norms and other codes of conduct prescribed by the domestic
government and regulatory authority. They are subjected to inspection and
investigations by Regulatory Authority regularly.

The trading in stocks is automated and screen
based and the settlement period has been shortened. Today almost all stock
exchanges work on T+2 settlement period basis. Moreover today trading is
done in rolling settlement. There are no settlement defaults as trade is
cleared by the Clearing Corporations set up by stock exchanges. Trading is
paperless as shares in dematerialized form are kept in investors’ accounts
with depositors. Almost all tradeable securities are transacted without
delay, transit loss and forgery in transparent manner with all information
contents. An important feature of today’s exchange market is that clients
through computers, brokers, stock exchange with automation screen based
trading, clearing corporation, depositories and clearing banks are having
interconnectivity. This network has resulted in reduction in frauds and
delay in settlement. Stock exchanges have transparent trading and have
achieved reduction in cost of transaction.

The companies listed on stock exchange for
trading have to sign listing agreement and have to observe conditions
specified in the agreement. The listed company has to file quarterly
financial statements of its operations and all material and sensitive
information with stock exchange regularly. Stocks markets work according to
guidelines and mandatory instructions of Regulatory body set up under
Government Act. Regulatory Authority generally regulates functioning of
stock exchanges, mutual funds, collective investment schemes, pension funds,
etc. as all of them operate in the market. Among the other intermediaries
being regulated are brokers, depositories, foreign financial institutions
and other institutions investing in securities. Among them, brokers are
closely regulated. Brokers are registered with Regulatory authority and have
to follow all disclosure norms, Capital Adequacy norms and risk containment
measures. In many countries like India, Government is encouraging
corporatisaton of brokers to make them more methodological and financially
strong. There are stringent laws and punishment for brokers, traders and
other intermediaries associated with capital market for economic offences
like frauds, manipulations, violation of regulatory norms, insider trading
and violation of laws relating to volatility in the market.

Traders in stocks markets have a tendency to have
exceedingly huge exposure and indulge in short selling, long buying and
carry forward transaction. Such activities result in default and huge
losses. To avoid such events, authorities impose margins on overall gross
exposure of the broker member of stock exchange or their exposure in
specific securities. Then there are volatility margins on movement of prices
of equity shares, an exchange can use even circuit breakers. Authorities can
halt the trading if market is going out of hand, in order to cool down the
market. Mark to market margins and Value at Risk based margins are used to
safeguard the settlement. Every stock exchange has to set up trade guarantee
fund to provide safe settlement and to avoid defaults and Investors
Protection Fund to protect investors.

Despite all precautions, measures and
mandatory steps, transparency norms, disclosure norms on entry of firms,
markets have shown adverse disruptions. For instance more than 2000
companies in India raised capital from the primary market during 1992-93 -
1994-95 and disappeared from the market. Millions of investors suffered a
loss of more than Rs.2,000 crore resulting in confidence crisis and erosion
of household investors base. Though there are stringent penalties available
which could have been imposed but because of non-ethical approach of
authorities, nothing could be done. This is the weakness of legal system in
capital market. As regards trading of securities, the market has experienced
many crippling events in many countries in the world and recently in East
Asia. In India about 10 thousand companies are listed for trading of which
only 30 per cent are traded but 60 per cent of them account for 80 per cent
of turnover. Turnover has risen from Rs.400 bn. in 1992 to Rs.10233 bn. in
2004 but number of companies has almost remained constant. Since in
capitalistic mode of securities trading, market does not investigate the
quality of demand and nature of supply, stock prices reflect large scale of
speculation; due to squaring up facility in the settlement system and low
margin requirement exist unabated. In India, a trader can do any amount of
short selling or can accumulate a long position and can square up trade
before the end of settlement. The speculative trading in India resulted in
crash of market. In 1992 end, BSE sensex dropped to Rs.2222 bn. from Rs.4467
bn. resulting in a loss of Rs.2245 bn. for investors. A large number of
households suffered heavy losses. Many banks which financed speculative
trade became insolvent leading to their merger with strong banks. Even a few
foreign banks came in problems. Again, in 2000-2001 market capitalization at
BSE suffered a fall of Rs.3412 bn. from Rs.9128 bn. in 1999-2000 to Rs.5716
bn. in 2000-01. Investors again lost Rs.4003 bn. in 2002-03. Investors
suffer either loss or gains of the order of billion of rupees on alternative
days. Such market cannot be considered a fair market. In order to show
market vagaries, Table 1 was prepared to record absolute increase/decrease
or gains or losses in the Indian stocks market.

TABLE 1 : INDIAN STOCK MARKET

BSE SENSEX FOR THE MONTH
OF JANUARY 2005.

Date

Total Market Capitalisation

Rs. (crore)

Absolute Increase

SENSEX Full Mkt. Value (Rs. Crs.)

Absolute Increase

Decrease (-)

SENSEX Turnover

(Rs. Crs.)

12/31/04

383002.34

735528.13

621.02

1/3/05

387440.38

4438.04

746152.72

10624.59

631.87

1/4/05

385805.27

-1635.11

742448.69

-3704.03

705.29

1/5/05

374657.95

-11147.32

718048.14

-24400.55

1179.21

1/6/05

369353.56

-5304.39

707976.57

-10071.57

1080.04

1/7/05

372431.64

3078.08

713778.77

5802.20

913.62

1/10/05

366307.42

-6124.22

701891.66

-11887.11

651.60

1/11/05

361332.96

-4974.46

693576.65

-8315.01

798.36

1/12/05

354357.78

-6975.18

680948.36

-12628.29

1166.77

1/13/05

361228.03

6870.25

694472.68

13524.32

902.11

1/14/05

358484.99

-2743.04

688601.45

-5871.23

834.90

1/17/05

359660.66

1175.67

690611.29

2009.84

885.56

1/18/05

359561.04

-99.62

690404.17

-207.12

1038.63

1/19/05

358455.94

-1105.10

688119.96

-2284.21

775.35

1/20/05

359031.85

575.91

688008.02

-111.94

1246.23

1/24/05

354571.86

-4459.99

680057.73

-7950.29

861.06

1/25/05

357855.40

3283.54

686599.80

6542.07

1036.14

1/27/05

362294.56

4439.16

696154.07

9554.27

1003.21

1/28/05

372726.58

10432.02

715500.35

19346.28

1150.32

1/31/05

380672.75

7946.17

731784.91

16284.56

1111.59

Table 2 contains company wise figure of paid-up
capital and their market capitalization. It would be seen that market value
of paid-up capital has shown more than 1000 per cent rise on account of
manipulation.

Table 2 : Paid-up share value and market capitalization
of selected stocks traded on Bombay Stock Exchange at end of December 2004.

(Figures are in Rs. crore)

Sr. No.

Name of Stock

Issued and Paid-up Capital

Market Capitalisation

Column3 as a percentage of Column 2

Volatility

In per cent

(1)

(2)

(3)

(4)

(5)

1

ABB

42

4116

9800

1.93

2

ACC

178

6036

3391

2.19

3

Bajaj Auto

101

11446

11333

1.87

4

Bharati

1853

40098

2164

3.25

5

BHEL

245

18769

7661

3.03

6

BPCL

300

13778

4593

2.88

7

CIPLA

60

9530

15884

2.13

8

Colgate

136

2436

1791

1.72

9

DABUR

29

2681

9245

2.74

10

DRREDDY

38

6622

17426

2.36

11

GAIL

846

1953

231

3.79

12

GLAXO

87

6724

7729

1.82

13

GRASIM

92

12125

13179

2.27

14

GUJMBCEM

179

7230

4039

2.26

15

HCL TECH

60

10235

17058

2.52

16

HDFC

248

19050

7682

2.35

17

HDFC Bank

287

14910

5195

2.60

18

Hero Honda

40

11429

2853

2.41

19

Hindal Co.

92

13156

14300

2.27

20

Hind Liver

220

31566

14348

2.01

21

Hind Petro

339

13626

4019

2.60

22

ICICI Bank

736

27313

3711

2.47

23

INDHOTEL

45

2429

5398

1.90

24

Infosystem

134

56028

41812

2.09

25

Reliance37

1396

74525

5338

2.20

26

Sail 39

4130

25898

6127

2.49

27

VSNl 48

285

6615

2321

3.13

28

Wipro 49

140

52408

37434

2.84

29

Zee Tele.

41

7077

17261

3.19

30

TISCO

530

21314

3854

2.82

Since stock markets represent the capitalistic
society, maximization of profit and wealth is the primary goal. Even the
corporate governance has been designed for maximizing shareholders wealth
without considering the ethical part of it. Similarly, in stock markets
number of developments have been made to boom the market in the name of
liquidity. I may clarify that stock market concept is an ideal one but it
has been sacrificed on the alter of liquidity. Liquidity does not mean the
turnover rise of the same number of shares in the market capitalisation due
to overtrading. Turnover increase means rise in quantity of real-shares
traded and liquidity means easiness to sell without loss of capital and
without delay at minimum transaction cost. Some of the reasons for damaging
the Indian stocks market and other stock markets are given below:

I. Brokers / traders are allowed to do
total (gross) trade equal to many times of their capital or funds with
clearing corporation. This empowers brokers to indulge in overtrading.

II. Banks are permitted to provide
finance to brokers for financing trade in securities.

III. Since only margin money is required
at the time of making order for buying the stocks, such money can be
borrowed from banks or other brokers. As such purchasing the shares when an
investor does not have finance, is undesirable and leads to increase in
stocks’ prices.

IV. Short selling and long buying
generates volatility and uncertainty in the market.

V. Trading in the market is done to reap
high profits and not with the intention of investment. In India more than 60
per cent of trading is speculative and about 40 per cent is done on delivery
basis.

VI. Margining system is very liberal and
margins are not kept in cash. Keeping securities as margin gives leverage to
the traders.

VII. Taxation system is faulty as
capital gains are exempted from tax. This fiscal incentive motivates traders
to speculate and earn abnormal profits.

We have given the adequate idea of
weaknesses of capitalistic mode of functioning of stock markets. The
following section is devoted to operational frame work of Islamic stock
markets which is expected to eliminate shortcomings of capitalistic mode of
stock trading.

Section IV : Operational Frame Work of Islamic
Stock Market

Primary Market

Theoretical aspects of Islamic stock market were
discussed in the second section (II) and therefore in this section we
attempt to discuss some operational features. We covered all provisions
relating to issue of stocks in primary market. Investors in stocks in
Islamic view should have intention of real ownership rather than trading.
Shariah Regulatory Authority will have to impose lock-in-period of 4 to 5
years so that only real investors purchase the shares. Of course the company
should offer buy-back facility in order to provide liquidity for investors
in need.

Islamic company should issue stocks on the basis of
fixed price method calculated by appraising agency which should have free
access to all available information from the issuing company. An issuer
company before issue should obtain clearance from Shariah Regulatory
Authority that there is no activity based on Riba and gharar in issue
process. Mutual funds and other financial institutions intending to invest
in Islamic instruments should submit quarterly Shariah Compliance Statement.

Pricing of shares can also be based on Present Value
(PV) of future cash flows or on the basis of net worth of the company as
discussed in section II. A company should not charge premium on issue
without having any relationship with net worth and reputation or goodwill.
Actually price of issued share should reflect its economic value. Allocation
of stocks should be done on pro-rata basis when demand is more than stocks
issued or there is an over subscription. A company can announce issue on
stock exchange screen also to have wider awareness among the investors.
Modern system of capitalistic process of offering securities through Book
building process in which bids at various prices from investors or syndicate
members are received and demand for stocks is determined on the basis of
these bids and thereafter it’s price is discovered based on the basis of
average price estimated by the merchant bankers and advisers to issue. In
India book building has two options namely 75 per cent book building route
and 100 per cent book building. A more than 60 per cent of offer is
allocated to institutional buyers and rest to non-institutional and small
investors. Since average price is fixed on the basis of book building route
in which investors buy 60 per cent, average price is worked on the basis of
higher prices in their bids. The remaining 40 per cent is also allocated on
the average price and not on the price which small investors have quoted.
However, Islamic stock markets should not adopt book building method because
many times it involves over pricing by institutions due to their mutual
understanding with the promoters. Fixed price issue method should be
followed by Islamic market. An issuer will be always conservative in pricing
the issue so that issue is fully subscribed. Hence price is always on the
lower side. But book building price is aggressive and harms the investors.
Moreover book building method does not offer enough opportunity to
individual investors.

1) Secondary Market in operation

The most important organ of secondary market
is stock exchange which provides facility of purchase and sale of stocks.
The stock exchange can be organised either as a voluntary or non-profit
making association or public limited company owned by shareholders or
company limited by guarantee. The stock exchange as a public limited company
owned by equity holders would be compatible with Shariah provided governing
board members do not practice borrowing and lending operations and have no
transaction activities on stock exchange. Moreover, executives of stock
exchange should not be trader/broker on the stock exchange otherwise there
will be no guarantee that stock exchange will function in fair manner. Stock
exchanges have to be supervised and regulated by Shariah Regulatory
authority on the basis of Shariah principles. Stock exchanges will supervise
listed companies whether they follow Islamic provisions and listing
agreement and stock exchange should work as a trustee to protect the
interest of investors and particularly small investors.

2) Instrument to be traded

Besides equity shares and preference shares
right shares also can form the part of Islamic instruments to be traded.
Mutual funds should promote equity linked schemes to mobilise funds to
invest in equity shares and other Islamic instruments. Such units of mutual
funds can be transacted on stock exchange. The listed companies can also
list their bonds and debentures which should not be interest based
instruments but dividend based instruments. Bonds can be traded in the
market but holders of bonds cannot be owner of the company and also they can
not participate in the management of company. Islamic bonds can be similar
to fixed deposits of Islamic banks but tradeable. There will be one
advantage to bondholders, they can be the first claimant in case company is
liquidated. Islamic certificates of deposits also can be issued by Islamic
companies and traded in the market. Islamic capital market in Malaysia
offers many Islamic instruments. These include Islamic equity funds,
balanced money market and bonds funds. These instruments are component of
Shariah based Unit Trust funds. Islamic global Sukur Ijarah and Islamic
derivatives are also instruments which can be listed on stocks exchange.
Derivatives should be primarily used for hedging risk and can be traded with
capital gains around the price + premium paid by the buyer of a derivative.

3) Principles of Trading

We have already analysed certain transaction
activities which Islam does not permit. These include overtrading, short
selling, frauds, insider trading, cornering information, lack of
transparency and absence of fairness in trade. These all hinder the
competitive market functioning. High booms and crash in the securities
market is a sign of imperfection. Even after all paraphernalia attached to
stocks market trading of stocks does not result in real value addition.
Competition result in high productivity, efficiency and gains for economy
and society. Competition is healthy and productive if it can increase
quality, efficiency and equity rather than cut throat competition by using
unscrupulous and unethical tactics. Traders in market develop animal spirit
and generate uncertainty and risk. To control such environment, trading
needs to be restrained by putting cap on gross transaction of broker which
should not exceed level of capital adequacy of broker. Broker should pay
penalty if gross trade exceeds his capital deposits with the clearing
corporation. Even stock-wise exposure should be subjected to a limit. If
trader is found in manipulation activities, there should be severe cash
penalty and cancellation of registration of broker. Banks and financial
institutions should not be permitted to lend for financing the trading in
securities. Islamic trading system should be 100 per cent delivery based and
dematerialized. Only equity based company can participate in stock market
and should observe Shariah in absolute sense. Islamic stock market will
require all paraphernalia of modern exchange. Automated trading with all
efficient mechanism is must for Islamic market.

T+0 Rolling Settlement and Clearing of Trade

Islamic stock exchange is supposed to
discourage and prohibit short selling and long buying, manipulation in sales
and purchase of stocks and frauds in transaction. In order to achieve these
targets, execution and settlement of transaction should be as rapid as
possible so that no one gets the chance to distort the market. As soon as
the orders to buy or sell are routed through automated trading system, they
should be matched to sell or buy orders of the counterparty. All orders have
to be matched on a time / price priority basis. Islamic stock exchange will
have to adopt rolling settlement system on T+0 basis. It means trade
executed today has to be settled tomorrow by actual delivery of shares and
cash payment. In such a mechanism, there is no possibility of manipulations.
In almost all advanced stock exchanges, settlement of trade is done through
clearing corporation which works as opposite party to seller as well as
buyer and pay in and pay out is routed through it. Clearing corporation
should be a guarantor of safe trade. Clearing corporation will have to be
setup as an independent subsidiary of Islamic stock exchange. As such
trading in stocks should have three phases, viz. trading, clearing and
settlement. White stock exchange provides platform for trading, the Islamic
clearing corporation determines the funds and securities obligations of the
trading members and ensures that the trade is settled through exchange. Thus
T+O eliminates fraud and manipulation in the system.

Islamic stock market warrant availability of
highly skilled investors. This needs professional education of high
standard. Accounting standards to be practiced by all participants in the
market and market sophistication require specialized training institutes. It
is necessary to caution that Islamic stock exchange is a very costly affair.
Stocks market have been facing traders in many forms like brokers on their
accounts, individual households, non-banks finance companies, mutual funds,
equity firms, foreign financial institutions, domestic financial
institutions, pension funds and provident funds. Among them foreign
financial institutions, should not be permitted to invest in Islamic stocks
as they are simply traders. Other institutions and individual investors can
be discouraged from overtrading in the market. All institutions like foreign
institutions, mutual funds should not be permitted to sell or buy the stocks
of a company beyond a limit. Heavy buying and selling should not impact the
price of stock even to a decimal extent in order to minimise impact cost.

Islamic stocks market should work as a
trustee for investors and have to watch performance of listed companies. As
soon as the stocks of a listed company record large fluctuations, stocks
market should display SWAT analysis of the company on screen. The Islamic
stock exchange statutorily should impose ban on rumours, incorrect estimates
of results of company and misinformation. The Islamic stock exchange can
announce divergence between stocks prices and real fundamentals of the
economy as well as those of company of which stock is under reference.

Muslim community has been lagging behind in
the technical knowledge relating to investment and financial markets. There
is a need to expand financial literacy among the Muslims. We can have
Islamic Financial Management institutions and investment experts to impart
education and working knowledge of Islamic investment principles. Awareness
is also very important. We will have to develop the sense of accountability
in the community as well as in the market players. Ethical values have to be
matured and strengthened.

S ection V : Conclusions of the paper

Islamic stock market can play a crucial role
in promoting equity investment and creating liquidity in the market and
simultaneously avoid frauds, manipulations, inside trading, short selling
and long buying. The capitalistic model of Indian stock market inspite of
all facilities, disclosure standards and accounting standards failed to
protect the investors and has crippled the confidence of investors. Many a
times even a whole nation has to face adverse financial insolvency. Since
financial markets are getting globalised and capital inflows are playing a
game of free rider in other economies Islamic market would have emerged with
stringent Shariah discipline and with most upto date technology and
education in financial literacy. Stock market efficiency will have to be
judged on the basis of growth of investment and capital formation. Minimum
volatility, minimum divergence of market price of stock from its intrinsic
value, severe punishment for violating the law and high level of financial
literacy in Islamic world, should be the prime goal of Islamic stock
exchange.

BIBLIOGRAPHY

1. Al-Satti Abdul Rahim
- ‘Shariah Compatible Futures’

Journal of King Abdul Aziz University,

Vol.-15, Jeddah.

2. Bear Larry Alan &
- Free Markets, Finance, Ethics and Law,

Bear
Maldonado Practice Hall, Englewood
Cliffs,

New Jersey.

3. Chapra, M. Umer
- Islam and the Economic Challenge,

The
Islamic Foundation and the International Institute of Islamic Thought, London.